By: Daniel T. Massy, CPA Waltz Group
The Importance of Monitoring Overhead Rates During Inflation
Over the last couple of years, businesses across all industries – especially contractors – have dealt with rising employee and human capital costs and rapidly increasing input costs. Although inflation data is now below 5% for April 2023 and projected to decrease slightly in May 2023, those figures are still above the norms of the previous two or three decades.
For the most part, contractors have done a good job of passing along the increase in direct costs to their customers. However, ensuring that overhead is allocated appropriately during significant price changes is also a key factor in determining both the success of projects and the appropriate fees to charge to customers.
Allocating overhead to jobs requires determining the indirect job costs (such as payroll taxes), insurance, utilities, depreciation, some wages, and other costs that flow into a job secondarily from field labor, subcontractors, equipment, and materials. Most companies will use a standard overhead allocation rate throughout the year and true it up occasionally. But, with the atmosphere of price changes, it is vital to check overhead allocation more frequently than that.
Contractors may choose multiple ways to allocate overhead. They can divide the pool of indirect costs by direct labor to get an overhead rate to add to direct labor. Other companies may divide indirect costs by total direct costs to obtain an overhead rate that is tacked onto all direct job costs. Regardless of the methodology, it is likely that the indirect costs have not increased as drastically as the direct costs, which makes the numerator in our equation lower in comparison to the rapidly increasing denominator. Consequently, this may cause overhead to decrease as a percentage of direct costs.
The way to determine if indirect costs are accurately allocated to each job is to schedule all jobs performed during a period and add up all their direct costs, as well as the standard indirect costs allocated based on the percentage calculated. If at the end of this process – when all jobs for the period are added up – the gross profit is less than the gross profit on the income statement, then overhead has been overapplied on a job-by-job basis. If the gross profit on the job schedule is higher than on the income statement, then overhead has been under applied.
It is imperative to recognize if overhead is overapplied or under applied because an under application makes jobs look better than they were. Over application of overhead indicates that jobs are performing better than they appear.
Both under applied and overapplied overhead are also key indicators in bidding processes. Suppose the application of indirect costs is not appropriate. In that case, contractors may be bidding too high or too low on projects and either lose out on opportunities because bids are too high or lose out on profitability because bids are too low.
The more frequently overhead costs and indirect cost applications are reviewed internally, the better a contractor will stay competitive and profitable.
Dan Massey is Principal in Charge of Walz Group CPA’s Assurance Division. He performs audit services for clients in many industries, focusing on construction, entertainment production, and not-for-profit entities. Dan is a member of the American Institute of Certified Public Accountants (AICPA) and the Pennsylvania Institute of Certified Public Accountants (PICPA). He is also chairman of the C.O.R.E. Task Force for the Keystone Chapter of Associated Builders and Contractors. Connect with Dan on LinkedIn or contact our office to get in touch.
Posted July 10, 2023
